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Chapter Seven
Activity-Based Costing: A Tool to Aid Decision Making
8-2
Activity Based Costing (ABC)
ABC is designed to provide managers with cost
information for strategic and other decisions that
potentially affect capacity and therefore affect fixed as well as variable costs.
ABC is agood supplement to our traditional
cost systemI agree!
8-3
Learning Objective 1
Understand activity-Understand activity-based costing and how based costing and how
it differs from a it differs from a traditional costing traditional costing
system.system.
8-4How Costs are Treated Under
Activity–Based Costing
ABC differs from traditional cost accounting in three ways.
Manufacturingcosts
Nonmanufacturingcosts
ABC assigns both types of costs to products.
Traditionalproduct costing
ABCproduct costing
8-5How Costs are Treated Under
Activity–Based Costing
ABC does not assign all manufacturing costs to products.
Manufacturingcosts
Non manufacturingcosts
Traditionalproduct costing
ABCproduct costing
All
Most, butnot all
Som
e
ABC differs from traditional cost accounting in three ways.
8-6How Costs are Treated Under
Activity–Based Costing
Plantwide Overhead
Rate
DepartmentalOverhead
Rates
Activity–BasedCosting
Number of cost pools
Level of
com
ple
xit
y
ABC uses more cost pools.
ABC differs from traditional cost accounting in three ways.
8-7How Costs are Treated Under
Activity–Based Costing
ABC uses more cost pools.
Each ABC cost pool has itsown unique measure of activity.
ABC differs from traditional cost accounting in three ways.
Traditional cost systems usually relyon volume measures such as direct laborhours and/or machine hours to allocate
all overhead costs to products.
8-8
ActivityAn event that causes the consumption of overhead
resources.
Activity Cost Pool
A “cost bucket” in which costs related to a particular
activity measure are accumulated.
$
$
$ $
$$
How Costs are Treated UnderActivity–Based Costing
8-9
Activity Measure
An allocation basein an activity-based
costing system.
How Costs are Treated UnderActivity–Based Costing
The term cost driver is also used to refer to an
activity measure.
8-10
Simple countof the number oftimes an activity
occurs.
Transactiondriver
A measureof the amountof time neededfor an activity.
Durationdriver
Two common types of activity measures:
How Costs are Treated UnderActivity–Based Costing
8-11How Costs are Treated Under
Activity–Based Costing
Traditional cost systems usually rely on volumemeasures such as direct labor hours and/or machine
hours to allocate all overhead costs to products.
ABC definesfive levels of activity
that largely do not relateto the volume of units
produced.
8-12
Manufacturingcompanies typically combine
their activities into fiveclassifications.
Unit-LevelActivity
Batch-Level Activity
Product-LevelActivity
Customer-LevelActivityOrganization-
sustainingActivity
How Costs are Treated UnderActivity–Based Costing
8-13Characteristics of Successful
ABC Implementations
Strong topmanagement support
Cross-functionalinvolvement
Link to evaluationsand rewards
8-14
Classic Brass – An ABC Example
SalesCost of goods sold 3,200,000$
Direct materials 975,000$ Direct labor 351,250 Manufacturing overhead 1,000,000 2,326,250
Gross margin 873,750 Selling and administrative expenses
Shipping expenses 65,000 Marketing expenses 300,000 General administrative expenses 510,000 875,000
Net operating incomeoperating loss (1,250)$
Classic BrassIncome Statement
Year Ended December 31, 2005
Manufacturing overhead is allocated to products usinga single plantwide overhead rate based on machine hours.
8-15Define Activities, Activity Cost Pools,
and Activity Measures
At Classic Brass, the ABC team, selected the following activity cost pools and activity
measures:
8-16
• Customer Orders - assigned all costs of resources that are consumed by taking and processing customer orders.
• Product Designs - assigned all costs of resources consumed by designing products.
• Order Size - assigned all costs of resources consumed as a consequence of the number of units produced.
• Customer Relations – assigned all costs associated with maintaining relations with customers.
• Other – assigned all overhead costs that are not associated with the other cost pools.
Define Activities, Activity Cost Pools,and Activity Measures
8-17
Learning Objective 2
Assign costs to cost Assign costs to cost pools using a first-pools using a first-stage allocation. stage allocation.
8-18Assign Overhead Costs
to Activity Cost Pools
8-19Assign Overhead Costs
to Activity Cost Pools
Direct materials, direct labor, and shipping are excludedbecause Classic Brass’ existing cost system can directly
trace these costs to products or customer orders.
8-20
At Classic Brass the following distribution of resource consumption across activity cost pools is determined.
Assign Overhead Coststo Activity Cost Pools
8-21
Indirect factory wages $500,000Percent consumed by customer orders 25%
$125,000
Assign Overhead Coststo Activity Cost Pools
8-22
Factory equipment depreciation $300,000Percent consumed by customer orders 20%
$ 60,000
Factory equipment depreciation $300,000Percent consumed by customer orders 20%
$ 60,000
Assign Overhead Coststo Activity Cost Pools
8-23Assign Overhead Costs
to Activity Cost Pools
8-24
Learning Objective 3
Compute activityCompute activityrates for cost pools.rates for cost pools.
8-25
Calculate Activity Rates
The ABC team determines that Classic Brass will have these total activities for each activity cost pool . . .
1,000 customer orders, 400 new designs, 20,000 machine-hours, 250 customer relations activities.
Now the team can compute the individual activity rates by dividing the total cost for each activity by
the total activity levels.
8-26
Calculate Activity Rates
8-27
Traced Traced Traced
Activity-Based Costing at Classic Brass
DirectMaterials
DirectLabor
ShippingCosts
Overhead Costs
Cost Objects:Products, Customer Orders, Customers
8-28
Activity-Based Costing at Classic Brass
DirectMaterials
DirectLabor
ShippingCosts
Cost Objects:Products, Customer Orders, Customers
OrderSize
CustomerOrders
ProductDesign
CustomerRelations
Other
Overhead Costs
First-Stage Allocation
8-29
Activity-Based Costing at Classic Brass
DirectMaterials
DirectLabor
ShippingCosts
Cost Objects:Products, Customer Orders, Customers
CustomerOrders
OrderSize
CustomerRelations
Other
Overhead Costs
First-Stage Allocation
Second-Stage Allocations
$/Order $/Design $/MH $/Customer
Unallocated
ProductDesign
8-30
Learning Objective 4
Assign costs to a cost Assign costs to a cost object using a second-object using a second-
stage allocation. stage allocation.
8-31
Classic Brass Information
Standard Stanchions1. Requires no new design resources.2. 30,000 units ordered with 600 separate orders.3. Each stanchion requires 35 minutes of machine
time for a total of 17,500 machine-hours.
Custom Compass Housing1. Requires new design resources.2. 400 separate orders.3. 400 custom designs prepared.4. 1,250 compass housings produced, requiring 2
machine-hours each for a total of 2,500 machine-hours.
Assigning Overhead to Products
8-32
Assigning Overhead to Products
8-33
Let’s take a look at how Classic Brass system works for just one of the 250 customers – Windward Yachts who placed
a total of three orders.
Orders1. Two orders for 150 standard stanchions per order.2. One order for a custom compass housing.
Machine-hours1. The 300 standard stanchions required 175 machine-hours.2. The custom compass housing required 2 machine hours.
Assigning Overhead to Customers
8-34
Assigning Overhead to Customers
8-35
Learning Objective 5
Use activity-based Use activity-based costing to compute costing to compute
product and customer product and customer margins.margins.
8-36
Prepare Management Reports
CustomStandard Compass
Stanchions Housings TotalSales 2,660,000$ 540,000$ 3,200,000$ Direct costs
Direct material 905,500 69,500 975,000 Direct labor 263,750 87,500 351,250 Shipping 60,000 5,000 65,000
Product Margin Calculations
The first step in computing product margins is togather each product’s sales and direct cost data.
8-37
Prepare Management Reports
Product Margin CalculationsThe second step in computing product margins is toincorporate the previously computed activity-based
cost assignments pertaining to each product.
CustomStandard Compass
Stanchions Housings TotalSales 2,660,000$ 540,000$ 3,200,000$ Direct costs
Direct material 905,500 69,500 975,000 Direct labor 263,750 87,500 351,250 Shipping 60,000 5,000 65,000
ABC cost assignmentsCustomer orders 192,000 128,000 320,000 Product design 252,000 252,000 Order size 332,500 47,500 380,000
8-38
Prepare Management Reports
Product Margin Calculations
The third step in computing productmargins is to deduct each product’sdirect and indirect costs from sales.
Sales 2,660,000$ 540,000$ Costs
Direct material 905,500$ 69,500$ Direct labor 263,750 87,500 Shipping 60,000 5,000 Customer orders 192,000 128,000 Product design 252,000 Order size 332,500 47,500
Total cost 1,753,750 589,500 Product margin 906,250$ (49,500)
CustomStandard Stanchions Compass Housings
8-39
CustomStandard Compass
Stanchions Housings TotalSales 2,660,000$ 540,000$ 3,200,000$ Total costs 1,753,750 589,500 2,343,250 Product margins 906,250$ (49,500)$ 856,750$
Less costs not assigned to products:Customer relations 367,500 Other 490,500 Total 858,000
Net operating incomet operating loss (1,250)$
Product Margin Calculations
The product margins can be reconciled withthe company’s net operating income as follows:
Prepare Management Reports
8-40
Prepare Management Reports
Customer Profitability Analysis The first step in computing Windward Yachts’ customer margin
is to gather its sales and direct cost data.
WindwardYachts
Sales 11,350$ Direct costs
Direct material 2,123 Direct labor 1,900 Shipping 205
8-41
Prepare Management Reports
Customer Profitability Analysis The second step is to incorporate Windward Yachts’ previously
computed activity-based cost assignments.
WindwardYachts
Sales 11,350$ Direct costs
Direct material 2,123 Direct labor 1,900 Shipping 205
ABC cost assignmentsCustomer orders 960 Product design 630 Order size 3,363 Customer relations 1,470
8-42
Prepare Management Reports
Customer Profitability Analysis The third step is to compute Windward Yachts’ customer
margin ($699) by deducting all its direct and indirect costs from its sales.
Sales 11,350$ Direct costs
Direct material 2,123$ Direct labor 1,900 Shipping 205 Customer orders 960 Product design 630 Order size 3,363 Customer relations 1,470 10,651
Customer margin 699$
Windward Yachts
8-43Product Margins Computed Using
the Traditional Cost System
CustomStandard Compass
Stanchions Housings TotalSales 2,660,000$ 540,000$ 3,200,000$ Direct costs
Direct material 905,500 69,500 975,000 Direct labor 263,750 87,500 351,250
The first step in computing product margins is togather each product’s sales and direct cost data.
8-44Product Margins Computed Using
the Traditional Cost System
Plantwide manufacturingoverhead rate
$1,000,000 20,000 MH
= $50 per machine-hour=
The second step in computing product marginsis to compute the plantwide overhead rate.
Production DepartmentIndirect factory wages 500,000$ Factory equipment depreciation 300,000 Factory utilities 120,000 Factory building lease 80,000
Total manufacturing overhead 1,000,000$
Manufacturing Overhead Costs at Classic Brass
Machine-hoursStandard Stanchions 17,500 Custom compass Housings 2,500 Total machine-hours 20,000
8-45Product Margins Computed Using
the Traditional Cost System
The third step in computing product margins isallocate manufacturing overhead to each product.
Machine Overhead Overhead Hours Rate Allocated
Standard Stanchions 17,500 50.00$ 875,000$ Custom Compass Housings 2,500 50.00 125,000 Total overhead allocated to products 1,000,000$
17,500 hours × $50 per hour = $875,000
8-46Product Margins Computed Using
the Traditional Cost System
The fourth step is to actuallycompute the product margins.
Sales 2,660,000$ 540,000$ 3,200,000$ Cost of goods sold
Direct materials 905,500$ 69,500$ 975,000$ Direct labor 263,750 87,500 351,250 Manufacturing overhead 875,000 2,044,250 125,000 282,000 1,000,000 2,326,250
Product margin 615,750$ 258,000 873,750
Selling and administrative 875,000 Net operating incomet operating loss (1,250)$
CustomStandard Stanchions Compass Housings Total
Shipping expenses 65,000$ Marketing expenses 300,000 General administrative expenses 510,000
875,000$
8-47
Standard CustomStanchions Compass Housings
Product margins – traditional 615,750$ 258,000$ Product margins – ABC 906,250 (49,500) Change in reported margins 290,500$ (307,500)$
The Differences Between ABCand Traditional Product Costs
The traditional costsystem overcosts thestandard stanchionsand reports a lower
product marginfor this product.
The traditional costsystem undercosts the
custom compasshousings and reports
a higher productmargin for this product.
8-48Differences Between ABC and Traditional
Product Costs
There are three reasons why thereported product margins for the two
costing systems differ from one another.
Traditional costing allocates all manufacturing overhead to products. ABC costing only assigns manufacturing overhead costs consumed by products to those products.
8-49Differences Between ABC and Traditional
Product Costs
Traditional costing allocates all manufacturing overhead costs using a volume-related allocation base. ABC costing also uses non-volume related allocation bases.
There are three reasons why thereported product margins for the two
costing systems differ from one another.
8-50Differences Between ABC and Traditional
Product Costs
Traditional costing disregards selling and administrative expenses because they are assumed to be period expenses. ABC costing directly traces shipping costs to products and includes nonmanufacturing overhead costs caused by products in the activity cost pools that are assigned to products.
There are three reasons why thereported product margins for the two
costing systems differ from one another.
8-51
Targeting Process Improvement
Activity-based management is used in conjunction with ABC to identify areas that would benefit
from process improvements.
While the theory of constraints approach discussed in Chapter 1is a powerful tool for targeting
improvement efforts, activity rates can also provide valuable clues on
where to focus improvement efforts.
Benchmarking can be used to compare activity cost information with world-class standards of
performance achieved by other organizations.
8-52
Activity-Based Costing and External Reporting
Most companies do not use ABCfor external reporting because . . .
1. External reports are less detailed than internal reports.
2. It may be difficult to make changes to the company’s accounting system.
3. ABC does not conform to GAAP.
4. Auditors may be suspect of the subjective allocation process based on interviews with employees.
8-53
ABC Limitations
Substantial resourcesrequired to implement
and maintain.
Resistance tounfamiliar numbers
and reports.
Desire to fullyallocate all costs
to products.
Potentialmisinterpretation ofunfamiliar numbers.
Does not conform toGAAP. Two costing
systems may be needed.
8-54
End of Chapter 8